Thread by @0xsingletonly

UST failed. Many wondered if that’s the end of algorithmic stablecoins.

@fraxfinance wants to prove them wrong.

Learn how Frax is an innovative alchemy mixer, risk assessment and alphas.

This is part 6 of #stablecoinwar. Let’s dive in. 🧵 1/n

@fraxfinance A/ How FRAX works
In part 1 of our #stablecoinwar series, the crypto world gave you a quest to create the ultimate stablecoin.

You succeeded in creating 3 types of stablecoins- fiat-backed, crypto-backed and algorithmic. You've also learnt about the 3C framework- 2/n

@fraxfinance Each type of stablecoin trades off some aspect of collateral, capital efficiency and centralisation.

Now it's 2022, and the crypto world has another quest for you. 3/n

@fraxfinance They want you to create a new type of stablecoin.

This may feel difficult. Aren't there only 3 types of stablecoins? How do you create another type of stablecoin?

Don't worry, I've a little hint for you. 😁 4/n

@fraxfinance Imagine if you've a soda machine that can dispense any of the 3 drinks- coke, sprite and orange juice.

You now have to create a new flavor using this soda machine. What will you do? 5/n

@fraxfinance If you've answered- I'll just mix 2 drinks to create a new flavor, you're right! ✅

This is the insight into @fraxfinance- you just need to mix 2 types of stablecoins together!

What are the 2 types you'll choose then? 6/n

@fraxfinance We know that algorithmic stablecoins are the ideal dream- capital efficient and decentralised. Alright, let's pick algorithmic as the first flavor.

We need to make sure that our second flavor complements algorithmic, so let's consider algorithmic's downside. 7/n

@fraxfinance Algorithmic stablecoins can be highly volatile. In UST's case, it had a free fall to zero.

We need to pair algorithmic with something that is very stable. Is fiat-backed or crypto-backed a better fit? 8/n

@fraxfinance Well, we know that crypto-backed stablecoins' collateral can be highly volatile.

In contrast, fiat-backed stablecoins are usually more stable, especially if the underlying collateral is USD.

Did we get the correct answer? 9/n

@fraxfinance 💡 Yes we did!

@fraxfinance is an algorithmic-collateral stablecoin. It combines 2 different types of stablecoins.

Let's go through how this actually works. 10/n

@fraxfinance The most important aspect of a stablecoin is price stability. No one wants a stablecoin that has its price going around in fucking circles. ⭕️

Similar to UST, @fraxfinance uses an algorithm to maintain price stability. 11/n

@fraxfinance @fraxfinance promises that you can always redeem 1 FRAX for 1 USD of collateral and FXS (the governance token) and vice versa.

This mechanism allows for arbitrage, thus keeping the price of each FRAX at around 1 USD.

A quick example- 12/n

@fraxfinance Suppose 1 FRAX = 1.1 USD. We want to bring FRAX's price down to 1 USD.

1) Traders can put in 1 USD of collateral + FXS to mint 1 FRAX.
2) They will then sell this FRAX for 1.1 USD, thus making 0.1 USD profit.

Notice what happens in step 1? 13/n

@fraxfinance As new FRAX are minted, their supply increases. This brings FRAX's price down.

You may find this mechanism very similar to UST-LUNA. However, there is a key difference. 14/n

@fraxfinance In @terra_money, only #LUNA is used to maintain $UST's price stability. But @fraxfinance uses a mix of both collateral and FXS to maintain FRAX's peg.

Wait, how do we even decide what ratio of collateral and FXS to use?

Time to go through a central idea- collateral ratio. 15/n

@fraxfinance @terra_money FRAX starts off as being fully backed by USDC. In other words, its collateral ratio (CR) is 100%.

Remember how an algorithmic stablecoin works by having enough people believe in it?

Likewise, @fraxfinance decreases the CR when more users believe in FRAX. How do they tell? 16/n

@fraxfinance @terra_money They will look at the growth ratio. Uhh what, another ratio? No worries, let's break this down quickly!

Growth ratio = FXS liquidity / FRAX supply

Let me give you an easy interpretation! 17/n

@fraxfinance @terra_money A high growth ratio means that more FRAX can be redeemed with less percentage change in FXS supply.

E.g. FXS liquidity = 500, FRAX supply = 2. After redeeming 1 FRAX, we still have FXS liquidity of 501, a 0.2% increase.

What if FXS liquidity = 5, FRAX supply = 2? 18/n

@fraxfinance @terra_money After redeeming 1 FRAX, we have FXS liquidity of 6, a 20% increase. But why does this matter anyway?

Do you remember when do we redeem FRAX for FXS? We do so as part of the price stability mechanism when 1 FRAX < 1 USD.

This accounts for the most dire outcome. 19/n

@fraxfinance @terra_money The LUNA-UST death spiral occurred when people continually burned UST to mint LUNA. Each successive UST burnt led to exponentially increasing LUNA mint.

By only decreasing CR when growth ratio is increasing, @fraxfinance reduces the odds of death spiral.

Spot something? 20/n

@fraxfinance @terra_money @fraxfinance allows the market to settle on the CR! When people believe in FRAX, the CR will be lower; when people are fearful, the CR will be higher.

This is different from UST & USDC, which are 100% algorithmic & fiat respectively.

Time for our last concept- honoring CR! 21/n

@fraxfinance @terra_money When the CR decreases, there will be excess collateral. When the CR increases, there will be a shortage of collateral.

@fraxfinance needs to ensure that decollateralisation (reducing collateral) & recollateralisation (increasing collateral) goes smoothly.

Enter the AMOs. 22/n

@fraxfinance @terra_money AMOs are algorithmic market operations.

They are financial lego blocks with the 4 operations:
1) decollateralise
2) market ops
3) recollateralise
4) FXS1559, which specifies profit sources to be distributed to staked FXS holders

Let's go through an AMO example! 23/n

@fraxfinance @terra_money Collateral Investor

1) Decollateralise: place idle collateral in DeFi protocols
2) Market ops: Compounds investments
3) Recollateralise: Withdraw investments from protocols
4) FXS1559: Revenue from investments in protocols

There are a few other AMOs. 24/n

@fraxfinance @terra_money They include:
- Curve
- Uniswap V3
- FRAX lending

They have similar structure, so I'll let you read up yourself. 😃

Alright, here's a friendly flowchart to summarise your learning!

We'll go through risk assessment next. 25/n

@fraxfinance @terra_money B/ Risk assessment
I'll be honest. I'm not exactly sure. The system works well in theory, but UST sounded great when I read the whitepaper too.

What are some of my concerns? 26/n

@fraxfinance @terra_money 1) UST's tps limit affected the mint/redeem mechanism. Is this applicable to FRAX-FXS too?
2) The key to a stable peg is smooth recollateralisation. Is there a scenario that @fraxfinance incurs significant slippage as they recall the collateral?

My takeaway- 27/n

@fraxfinance @terra_money 1) Treat the governance token as the investment, not the stablecoin.
2) Use the stablecoin for transactions, but do not hold more than you can afford to lose.

I also defer to people smarter than me. 28/n

@fraxfinance @terra_money @0xroborosCap has done an analysis on FRAX and @fraxfinance.

Look at the numbers yourself, and DYOR! Next up- alphas for you. 29/n

@fraxfinance @terra_money @0xroborosCap C/ Possible alphas
Investment: If you believe in the innovations behind @fraxfinance, you can get their governance token FXS. 30/n

@fraxfinance @terra_money @0xroborosCap Building: @0xHamz also has a brilliant thread on how @fraxfinance needs to evolve. But the ideas also extend to other possible DeFi protocols. 31/n

@fraxfinance @terra_money @0xroborosCap @0xHamz That's it for the #stablecoinwar series!

Follow me @0x_armin to not miss the upcoming #multichainfuture series, where we will dive into #BTC, @ethereum and other L1s.

Like/Retweet the first tweet below to help your friends learn about @fraxfinance: 32/end